Midnight Express to Contagion?

As an economic crisis grips Turkey, CheckRisk has analysed the risk of contagion to other asset classes and the financial system. This report covers:

  • CheckRisk BankFox analysis of the risks to EU zone Banks
  • Threats to other EM countries
  • Turkish Risks
  • Overall Financial Market Risk

Financial pressures in Turkey have been increasing over the past three years; therefore, it should come as no surprise that the country is now facing a severe economic crisis. The timing is not accidental; it is just that risk presents itself often as if by surprise.

Since President Erdogan was re-elected last month, he has fired his finance minister and replaced him with his son-in-law. He also furnished himself with the power to select the next Central Bank Chief, thus ensuring that Central Bank independence is compromised. Interest rates have rocketed with the 10 Year Bond yield reaching an all-time high of 20.67% last week. The Turkish Lira has plummeted, and the crisis appears to be escalating. With high US dollar debt exposure and rising US interest rates, the trap has been well and truly set. Corporate Debt, according to some estimates is now $5.5 trillion. In total Corporate, financial and other debt denominated in US dollars represents just short of 70% of the Turkish economy. As a result, as the Lira plunges debt servicing costs are rising fast, corporate defaults are highly likely on that mountain of US dollar debt.

The bottom line is that the country is walking into a balance of payments crisis within weeks, as currency reserves are drained from the countries system. Big Wall Street names are predicting a banking crisis that could spread, but CheckRisk believes it is much more likely to be a financial market bond related contagion that has the potential to be more serious for global financial markets

CheckRisk BankFox

CheckRisk BankFox is our proprietary model for measuring and predicting the amount of financial distress in banking, insurance, and other financials. Bank Treasurers use it, as do Insurance Companies as well as Corporates to monitor and optimise risk exposure to financial counterparties. It also is a useful tool for measuring the distance to distress of systemic banks. At present, the European Banking System continues to show no serious signs of contagion. The mean distance-to-distress of Systemic European Banks in our model is 4. This means that the average systemic bank has a 1/50,000 chance of becoming distressed tomorrow. The reading is the strongest the banks have enjoyed since the financial crisis of 2008.

Source: CheckRisk

It has also been reported by Credit Suisse, Morgan Stanley, and Deutsche Bank that the European Banks with exposure to Turkey/Turkish Debt instruments are BBVA, Unicredit, ING, and BNP. The distance-to-distress of these specific names is well within normal levels indicating that market considers these banks to be well capitalised and able to absorb any expected losses associated with their exposures to Turkey.

Table 1: EU Bank Distance-to-Distress with exposures to Turkey
Source: CheckRisk
Source: CheckRisk

As a result, CheckRisk does not currently believe that the risk of a collapse in the Turkish economy is going to lead to a banking crisis in Europe. That is not to say that a liquidity crisis in Turkey would not affect the Turkish banking system. Indeed it is possible to see that as a balance of payments crisis unfolds liquidity will be drained from the banking system. This is likely to lead an IMF bailout, and clearly, financial market volatility would increase.

Banks go bust because they run out of liquidity, and if one lesson is to be learned from 2008 it is that banks holding illiquid assets, (and note most assets become illiquid when liquidity is needed) are the first to fall. The mistake has been, by many, to assume that bonds are indeed liquid assets.

So assuming that contagion risk to the European banking system is actually not that high on relative terms, should we still be concerned about Turkey? And the answer is an unequivocal yes.

Risks to other Emerging Markets

The contagion route into Europe and the global financial markets from Turkey will not be one based on the sort of logical analysis CheckRisk has highlighted in this piece. It is much more likely to be found in sentiment as the markets begin to appreciate that the US Federal Reserve is unlikely to halt the rise in US interest rates until there is some blood on the floor. As a result, there is a risk that investors dump Emerging Market investments en masse thus precipitating a much broader crisis. For the moment we believe investors will be more discerning, but it is easy to understand how such a risk might propagate. It is important to note that the spillover effects are already commencing in the more vulnerable EM’s. It is critical that investors monitor the situation and are aware that sentiment can be as damaging to financial markets as a full-blown economic crisis.

Turkish Risk 

The risk to Turkey’s economic and political system is a much more prescient and severe risk. It is likely unless there is a rapid policy U-Turn by Erdogan that the country will eventually need to be bailed out. Foreign Currency reserves are being drained, and a balance of payments crisis is looming. Usable reserves cover about 1.4 months of cross-border payments. A minimal margin for error in the face of foreign capital flows.

President Erdogan has already begun blaming the USA for its woes, and while sanctions have been imposed, this is a classic defensive mechanism and not dissimilar to the approach taken by Maduro in Venezuela. Fiscal policy needs to be reined in, and a lower growth rate accepted. We believe that capital controls and an IMF bailout are on the cards unless some action is taken soon, and this does not mean solely rises in interest rates, the genie has already left the lamp. An IMF bailout might well shake markets given the proximity to Europe and the size of the Turkish economy.

Overall Financial Market Risks

The present financial crisis in Turkey is deepening, at a time when US interest rates are rising, and rates will continue to do so until the US Federal Reserve believes that any excess heat in the US economy is controlled, and the spillover effect from a global crisis impacts the USA. As a result, we expect no imminent change in US interest rate policy.

The risk to financial markets then is not via the EU banking system as we have highlighted above, at least for the moment, it is via the bond markets as the ripple effect is transmitted to other emerging markets. Investors will soon realise that the USD debt created since 2008 has been borrowed in USD on a global basis and now interest costs and capital needs to be repaid in devalued currencies. The risk investors need to focus on is in financial market risk because stock markets globally are at or close to all-time highs, and bond markets are stretched. In a sense given the length of the present bull market in US equity markets (the longest in history if we get to September), it is almost as if investors are looking for a reason to have a pullback. This is often all it takes.

In our Breaking of Unconventional Monetary Policy (B.U.M.P) model it is clear that some of the principal components of risk, Currency and Trade Wars, Geopolitical Risk, and Synchronisation risk are interacting more frequently. Our Early Warning Risk Systems are showing a steady as she goes to output but with a trend towards higher risks. Our view remains, however, that the period from now until 2020 remains one of elevated risk for investors. Investors are no longer being paid to take risk, other than in much riskier bonds and corporate lending. Turkey is unlikely to be the straw that breaks the camels back, but it could be a catalyst to a sentiment change that leads to a more profound and more widespread correction.

If you would like to learn more about CheckRisk BankFox, our Early Warning Risk System (EWRS) or B.U.M.P  and how these models and our work can help you then please do not hesitate to contact one of the team at CheckRisk.